Good Tidings in 2011

The global economy may be coming up for a breach of fresh air in 2011. Fiscal and monetary policies around the world have been highly stimulated for three years. The additional monetary and fiscal stimulus measures by the U.S. could generate an upside surprise to its 2011 growth rate. Most emerging economies continue to grow rapidly. By the middle of 2011, most analysts may declare that the world has finally put the financial crisis behind.

The reality is quite different. The global economy is kept afloat by massive monetary and fiscal stimulus around the world. The main problem in the global economy – high costs and declining competitiveness in the developed world, and inflation plus asset bubbles in the developing world continue unabated. Either inflation in the developing world or unsustainable sovereign debt in the developed world will spark the next crisis.

China has an opportunity to gain immunity against the next crisis.

The last crisis started in the U.S. If China hadn't reformed a decade ago, it could have started in China. An economic crisis in China would have prolonged the U.S.'s economic cycle by bringing down oil and other commodity prices, which would have improved the U.S.'s cash flow.

The most likely candidates to trigger the next global crisis are the U.S.'s sovereign debt or China's inflation. When one goes down first, the other can prolong its economic cycle. China may have won the last race. To win the next one, China must tackle its inflation problem, which is ultimately a political and structural issue, in 2011. If China does, the U.S. will again be the cause for the next global crisis. China will suffer from declining exports but benefit from lower oil prices.

On the other hand, if China has a hard landing, the U.S.'s trade deficit can drop dramatically, maybe by 50 percent, due to lower import prices. It would boost the dollar's value and bring down the U.S.'s treasury yield. The U.S. can have lower financing costs and lower expenditures. The combination allows the U.S. to enjoy a period of good growth.

One could describe the global economy as a race between the U.S. and China, to see who goes down first.

This coming year is China's opportunity.

The Obama administration just passed a big tax reduction bill. This is happening even as the U.S. already has a massive fiscal deficit and the national indebtedness is the highest since the World War II. The Fed just reemphasized its commitment to QE 2. It has made its intention crystal clear: As long as the unemployment rate is high and inflation rate is low, it will continue with QE.

I have argued several times before why the U.S.'s stimulus won't bring lasting growth. I'm not sure that the stimulus advocates in the U.S. believe what they say. The real intention for the new Obama tax cut is to get him re-elected in 2012. The mid-term election this year shows that, unless the U.S.'s unemployment rate drops significantly, he will lose his re-election bid then.

The Fed's intention, I think, is to inflate away the U.S.'s debts. The U.S.'s household sector needs to cut its leverage by half to become normal again. If it is done through saving more, the U.S. economy will be weak for a long time, which would keep the fiscal revenue low and the government deficit out of control. The U.S. could slide into a vicious spiral. If the Fed manages to bring it down through inflation, the U.S. economy may escape such a fate.

Inflation is good for the U.S., because foreigners own nearly 100 percent of its GDP in financial assets. With its massive U.S. debt holdings, China will suffer especially hard. Indeed, if China's foreign exchange reserves evaporate in value, it becomes very vulnerable, unless its structural problems are solved.

Regardless of how one views the intentions and effectiveness of the U.S.'s policies, they lead to a good environment in 2011 for China to tackle its inflation problem without worrying about a big growth slowdown.

Stability, not fast growth, is China's priority.

China's nominal GDP may reach US$ 6 trillion in 2010. If it rises at 10 percent per annum in the next decade, half as much as in the past decade, it would reach US$ 15.6 trillion by 2020, rivaling the U.S.'s GDP today. Stable growth, rather maximum growth at high risk is now in China's best interest.

Some analysts argue that a developing country must go through a period of breakneck and unbalanced growth for it to jump out of poverty. I share this view. For most developing countries, they need to spend as much on infrastructure and increasing manufacturing capacity as possible. The conventional view on investment efficiency doesn't apply to developing countries. But, China has jumped through already. "Steady as she goes," can bring China into the developed world in the foreseeable future.

Now is not the time for China to take on too much risk for maintaining growth. Even a six percent growth rate is good enough for China. China should err on the conservative side in the trade off between growth and stability.

A big financial crisis is never about an innocent mistake. It is often due to policies that prolong the economic cycle while avoiding necessary structural changes. For the developed world, the fundamental problem is that its high cost society built after World War II isn't sustainable in the age of globalization, because its labor income is being pulled down by globalization, which decreases fiscal revenue for supporting the welfare society. Greenspan's bubble-prone liquidity policy gave incentive to the U.S.'s household sector to defend its lifestyle through increasing debt, which covered up the underlying structural problem for a decade.

The European sovereign debt crises are due to the same force. The Southern European countries were hit especially hard during the past decade of globalization. They were quite dependent on labor intensive manufacturing before. As these industries were wiped out, they turned to government largesse to sustain their living standards. The establishment of the euro allowed these countries to borrow at the German interest rate, which made the debt problem manageable for the time being. When the market saw through them, they had to pay third world interest rates. They must cut their public expenditures dramatically to stay solvent.

The U.S. is dealing with its consequences of its financial crisis by running up government debt. It is doing what some European countries have been doing. Of course, the Fed can monetize the government debt, i.e., the U.S. doesn't have to beg for help to deal with its public debt in the future. But, printing money on such a scale will likely lead to the total collapse of the dollar's value, like the Russian ruble in 1998, and result in hyperinflation. While hyperinflation is beneficial to the U.S. by wiping clean its foreign debt, the dollar will forever lose its reserve currency status that might be worth three percent of GDP per annum and over half of GDP in present value. The U.S. may not gain from such a solution.

Developing economies are suffering from inflation and asset bubbles. Globalization is bringing unprecedented amounts of capital into them as multinational corporations move to arbitrage the cost difference between developed and developing world. The low interest rates in the former have also sparked hot money flow into the later. Some inflation in the developing world is inevitable.

The asset bubbles are even more serious for the developing world. Globalization has brought prosperity to the developing world, but not evenly across their populations. The ones that hold jobs that the developed world still has enjoy first world wages. Those who compete against others in the developing world only receive third world wages. The former group pays less their counterparts in the developed world for living and has big savings to buy assets. It leads to rising asset prices. The governments are attracted by it as an easy revenue source. Hence, they support the bubbles.

The inflation and bubbles in the developing world are not yet destabilizing because the dollar is weak and the hot money supports their currency values. Historically, inflation becomes a crisis in the developing world when the dollar turns around and appreciates. However, it is possible for inflation to create a crisis without a currency crisis. It erodes the purchasing power of the people at the bottom. Social unrest can lead to political crisis.